Legal Liability

Chapter 5

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-1

 Learning Objective 1

Understand the litigious

environment in which
CPAs practice.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-2

 Changed Legal Environment

Audit professionals have a responsibility under

common law to fulfill implied or expressed
contracts with clients.

They are liable to their clients for negligence

and/or breach of contract should they fail to
provide the services or not exercise due
care in their performance.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-3

 Learning Objective 2

Explain why the failure of financial

statement users to differentiate
among business failure, audit
failure, and audit risk has
resulted in lawsuits.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-4

 Business Failure, Audit Failure,
and Audit Risk

Audit
failure
Business
failure
Audit
risk

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-5

 Business Failure, Audit Failure,
and Audit Risk

Business failure

It occurs when a business is unable to

repay its lenders or meet the
expectations of its investors because
of economic or business conditions.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-6

 Business Failure, Audit Failure,
and Audit Risk

Audit failure

It occurs when the auditor issues an

erroneous audit opinion as the result
of an underlying failure to comply
with the requirements of generally
accepted auditing standards (GAAS).

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-7

 Business Failure, Audit Failure,
and Audit Risk

Audit risk

It represents the risk that the auditor will

conclude that the financial statements
are fairly stated and an unqualified
opinion can be issued when, in fact,
they are materially misstated.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-8

 Learning Objective 3

Use the primary legal concepts

and terms concerning
accountants liability as a basis
for studying legal liability
of auditors.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5-9

 Legal Concepts Affecting Liability

Prudent person concept

Lack of privileged communication

Liability for the acts of others

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 10

 Legal Terms Affecting CPAs
Liability
Terms related to negligence and fraud:

Ordinary Gross
negligence negligence

Constructive
Fraud
fraud

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 11

 Legal Terms Affecting CPAs
Liability
Terms related to contract law:

Breach of Third-party
contract beneficiary

Constructive
Fraud
fraud

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 12

 Legal Terms Affecting CPAs
Liability
Other terms:

Common Statutory
law law

Joint and Separate and

several proportionate
liability liability

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 13

 Four Major Sources of Auditors
Legal Liability

Client Third party

Federal Criminal
securities laws liability

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 14

 Learning Objective 4

Describe accountants liability to

clients and related defenses.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 15

 Liability to Clients

The most common source of lawsuits

against CPAs is from clients.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 16

 Auditors Defenses Against
Client Suits

Lack of duty to perform

Nonnegligent performance

Contributory negligence

Absence of causal connection

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 17

 Learning Objective 5

Describe accountants liability to

third parties under common law
and related defenses.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 18

 Liability to Third Parties Under
Common Law

Ultramares doctrine

Foreseen users

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 Foreseen Users

Credit alliance

Restatement of torts

Foreseeable user

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 Auditor Defenses Against
Third-Party Suits

The preferred defense is

nonnegligent performance.

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 Learning Objective 6

Describe accountants civil

liability under the federal
securities laws and related
defenses.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 22

 Securities Act of 1933

The Securities Act imposes an

unusual burden on the auditor.

Section 11 of the 1933 act defines the

rights of third parties and auditors.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 23

 Securities Exchange Act of 1934

The liability of auditors under this act often

centers on the audited financial statements
issued to the public in annual reports or
submitted to the SEC as a part of
annual Form 10-K reports.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 24

 Auditor Defenses 1934 Act

Nonnegligent performance

Lack of duty

Absence of causal connection

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 25

 SEC Sanctions

The SEC has the power in certain circumstances

to sanction or suspend practitioners from
doing audits for SEC companies.

Rule 2(e) of the SECs Rules of Practice says:

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 26

 SEC Sanctions

The commission may deny, the privilege of

appearing or practicing before it in any way to
any person who is found by the commission
(1) not to possess the requisite qualifications to
represent others, or (2) to be lacking in character
or integrity or to have engaged in unethical or
improper professional conduct.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 27

 Racketeer Influenced and
Corrupt Organization Act

This act allows an injured party to seek treble

(triple) damages and recovery of legal fees
in cases where it can be demonstrated
that the defendant was engaged in a
pattern of racketeering activity.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 28

 Foreign Corrupt
Practices Act of 1977

This act makes it illegal to offer a bribe

to an official of a foreign country for
the purpose of exerting influence and
obtaining or retaining business.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 29

 Learning Objective 7

Specify what constitutes criminal

liability for accountants.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 30

 Criminal Liability

CPAs can be held liable under

criminal liability for accountants.

CPAs can be found guilty for criminal

action under both federal and state laws.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 31

 Sarbanes-Oxley Act

This Act makes it a felony to destroy

or create documents to impede or
obstruct a federal investigation.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 32

 Learning Objective 8

Describe what the profession and

the individual CPA can do and
what is being done to reduce
the threat of litigation.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 33

 The Professions Response
to Legal Liability
Research in auditing

Standard and rule setting

Set requirements to protect auditors

Establish peer review requirements

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 34

 The Professions Response
to Legal Liability
Oppose lawsuits

Education of users

Sanction members for improper conduct

and performance

Lobby for changes in laws

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 35

 Protecting Individual CPAs
from Legal Liability
Deal only with clients possessing integrity

Hire qualified personnel

Follow the standards of the profession

Maintain independence

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 36

 Protecting Individual CPAs
from Legal Liability
Understand the clients business

Perform quality audits

Document the work properly

Obtain an engagement and a representation letter

Maintain confidential relations

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 37
 Protecting Individual CPAs
from Legal Liability
Carry adequate insurance

Seek legal counsel

Choose a form of organization with limited liability

Exercise professional skepticism

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 5 - 38

 End of Chapter 5

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